Saturday, August 8, 2009

RANDALL W. FORSYTH, Riding the China Tiger

RANDALL W. FORSYTH, Riding the China Tiger, UP AND DOWN WALL STREET DAILY,

AUGUST 5, 2009,

"PONZI SCHEME" gets thrown around a lot since Bernie Madoff made it part of the popular vernacular but it's worth paying attention when Andy Xie uses it.

"Chinese asset markets have become a giant Ponzi scheme, writes the highly regarded former Morgan Stanley Asian economist, Andy Xie. "The prices are supported by appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn't enough liquidity to feed the beast."

(www.ritholtz. com) for bringing Xie's piece to my attention.)

The Shanghai Composite has nearly doubled from its lows last November, leaving the rallies in Western bourses in its dust. The rally in China also has produced the frenetic trading that are hallmarks of a bubble.

According to Canaccord Adams Morning Coffee research note, turnover in China's stock market hit $63 billion on July 29 -- exceeding the combine $58 billion combined volume in New York, London and Tokyo that day. And the latter would include the $1 billion average daily volume in the popular iShares STSE/Xinhua China 25 exchange-traded fund (ticker: FXI) on the New York Stock Exchange.

Others argue that high asset prices in China aren't a bubble but a reflection of the nation's high growth potential. "An element of judgment based on experience is inevitable when one calls a market boom a bubble. I have had a reasonably good record at calling bubbles in the past," Xie asserts with no false modesty.

"I wrote my doctoral thesis arguing that Japan was a bubble in late 1980s; a long report at the World Bank in early 1990s arguing that Southeast Asia was a bubble; research notes at Morgan Stanley in 1999 calling dot-com boom a bubble, and numerous research notes from 2003 onwards arguing that the U.S. property market was a bubble. On the other hand, I have never called something a bubble that turned out not to be a bubble."

China's property market has been bid up to levels that rental yields on commercial real estate are negligible, leaving price appreciation the only source of return, Xie explains. Moreover, local governments depend on taxes from property sales, so they keep prices aloft by carefully controlling land sales. State-owned companies borrow from state-owned banks to buy land from local governments. "The money circulates in the big government pocket." But the bubble results in overbuilding that leads to the bust and a surge in bad loans.

The stock market, he continues, is in the final frenzy. "The most ignorant retail investors are being sucked in by the rising momentum. They again dream of getting rich overnight."

That's especially true of the young, who can see their holdings gain more in value in a day than their monthly salaries, Xie continues. They usually lose, but the idea that government won't let the market drop is rooted in Chinese market psychology, especially before Oct. 1, the 60th anniversary of the Peoples Republic. "This sort of belief is self-fulfilling in the short term. The market tends to roll over around the time. If the past is of meaningful guidance, this wave will taper off before October," says Xie.

As always, bubbles are inflated by excess liquidity. "How far the bubble would go depends on the government's liquidity policy. The current bubble wave is very much driven by the government encouraging banks to lend and the super low interbank interest rate. As the Fed's interest rate is zero, the dollar is weak, China 's foreign exchange reserves are high, and the loan-deposit ratio is low, China could increase liquidity, which would expand the bubble further. However, other considerations may motivate the government to cool it off."

If so, China may engineer a soft landing for the economy -- if the global economy recovers -- but it would still mean a hard landing for asset markets. "However, if the global economy remains weak then, which is my view, both asset markets and the economy would have a hard landing," Xie concludes.

The key will be the dollar. The economist contends that weak dollar periods have always spurred emerging-market rallies as capital floods into those sectors, which is reversed when the dollar recovers. Not coincidentally, China and other emerging markets are at highs while the Dollar Index is declining and closing in on its record lows.

Xie thinks Chinese authorities will try to deflate the bubble in a stop-go fashion ‹withdrawing liquidity to bring down prices and expanding once they are deflated. The correction could begin in the fourth quarter but could lead to a renewed frenzy in 2010 when a new wave of liquidity is released, he says.

The ultimate end of the China bubble will come when the dollar reverses course from Federal Reserve tightening policy similar to the Volcker era in 1979-82 to counter soaring inflation. That could result in a collapse like the 1990s Asian crisis. But Xie sees this as a risk for 2012.

"Chinese asset markets have become a giant Ponzi scheme, writes the highly regarded former Morgan Stanley Asian economist, Andy Xie. "The prices are supported by appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn't enough liquidity to feed the beast."